Elements of an HVAC business valuation

What to look for in an HVAC business when buying or selling.

In the last few years there has been a significant  increase in M&A (Mergers and Acquisitions) activity in the HVAC segment.  This activity has moved from what used to be large transactions, down to smaller family-owned companies.

As owners face the decision to sell, or investors to buy, here are some elements to consider.

Financial performance

This is a core element of the business value; however, surprisingly it may not always be the most important to the transaction.

Key components of your financial performance are:

– Revenue
– EBITDA
– ROS – Return on sales
– ROA – Return on assets

There are several other metrics, which will be more or less relevant to the transaction depending on the type of business.

Here the key is how the business is performing comparing to its peers and the industry.  This information can be found in public federal and state databases, in privately-generated reports such as IBISWorld, and in business M&A portals databases.

A healthy business of course should show:

– Consistent, year-over-year (YOY) growth.
– Positive cash flow
– Healthy ROS
– Healthy balance sheet – Strong assets, low liabilities

Other financial metrics should be evaluated depending on the specifics of the business.

Operational performance

Another key element of a business value is the engine that makes it exist, the operation.  For operations we refer to all the assets that produce the goods and services that the business sells, as an example:
– Field and office service technicians
– Installers
– Fabricators
– Supervisors
– Field support team (crane operators, welders, builders, carpenters, etc.)
– Project managers
– Subcontractors
– Suppliers and partners

There are a number of ways to evaluate the effectiveness of the operations team, which include:

– Customer satisfaction
– Customer attrition
– Technician productivity
– Call-back rate
– First call resolution
– On-time project delivery
– On-budget project delivery
– Cost of poor quality

From the above, perhaps one of the most important is customer satisfaction, since its a measurement of the value that the customer perceives.  Another very important metric is on-budget delivery, since the business in the end has to be profitable.

Elements should be in place to measure the team’s performance and to drive continuous improvement.

Trends

It is possible that you have or find a business that has an spectacular moment; however, one must evalute the business historically.  A business can have a one-time moment of success or failure, which in both situations will affect its value.

A strong business will show a solid trend of good performance, which will be a reasonable indicator -although not a guarantee- of its future performance.

A business that has had one or two years of great performance following years of average performance should be looked into with detail, since there could be temporary situations that show good results and can suggest a higher intrinsic value, but may not continue in the future.  A typical situation is a one-time large project that may unlikely repeat in the near future.

Conversely, a business that has performed well throughout the years and has one tough year will not necessarily see its value affected if it can explain the drivers and more importantly, how those were corrected.

Team

Evaluate the strength of the existing team, starting by the leadership, all the way to field execution team.

You can assess the team by reviewing their background, experience, performance reviews, tenure in the company, and customer feedback.  Ultimately, this is perhaps the most critical element of the company, especially an HVAC company since its the team the one that drives all sales and execution.

An important consideration from the team is their tenure and time to retirement.  Unfortunately, the HVAC industry has experienced a shortage of labor for some time, which makes it particularly important to understand both time-to-retirement as well as talent replacement initiatives.

Assets

The value of the business increases depending on the assets that it owns.   Examples include vehicles, tools, land, buildings, equipment, cash, securities, among others.

Assets also include intangibles such as brand equity, trademarks, patents, intellectual property, and others that have an intrinsic value in the balance sheet and are accepted by industry and IRS guidelines.  

Liabilities

Same as the value of the business increases with the assets that it has, the value decreases with liabilities.  Liabilities include long-term and short-term debt, employee accrued liabilities (stock options, retirement benefits, etc.), warranties, bad debt, among others. 

Notice that at times a business may not have a documented liability; however, this is latent intrinsically.  Examples include:

– Lawsuits.  A dispute may derive in a lawsuit which may result in significant costs and obligations to the company.
– Warranties.  Not all businesses accrue for warranty reserves, which can range between 3-8% or more of sales.
– Undocumented obligations.  These are customer-specific concessions that may not be included in an agreement but represent a cost.  Examples include extended warranties, upgrades in new construction or retrofits, verbal service arrangements, among other.

Growth potential

This is a combination of industry and market.  Usually the HVAC industry as a whole grows between a 2% to a 5% YOY, barring any major macroeconomic abnormalities.  Industry reports from reputable research companies publish every year a multi-year outlook, which can be used to understand the general growth potential.

In this area though we are more interested in the market growth potential, locally.  While nowadays AC is almost a basic necessity some markets may have more potential than others, driven both by economic development, economy, disposable income, and other factors.

Elements to consider include market size, economic development, competitors and new entrants, availability of equipment and supplies, local laws and regulations, barriers to entry in the specific market where the business operates, among others.

Recent changes

Recent changes in the industry, regulatory environment, and business also have impact on its value.  Understanding these external changes can be achieved through research. 

Internally, consider and evaluate recent changes within the team, recent departures of key members -especially sales-, loss of a major customer account, loss of a key supplier, loss of a license-holder, sale or divestiture of assets, among other.

Adding all together

There are several valuation methodologies widely known, including multiples of free-cash-flow, multiples of sales, discounted cash flow, comparables analysis.  In transactions of business selling less than $15M a multiple of free-cash-flow is the most common.  This though is just a starting point.  The value of the business will be affected by the elements described above and others not mentioned in this article but will be unique to the specific company.

Notice that the calculated value of the business is one dimension; another different but equally -if not more- important is the value that the business represents to a potential buyer. 

This value will be a combination of the intrinsic calculated value, plus the value of all the potential synergies that the buyer will be able to realize.  For more information about synergies read our article titled “M&A Synergies and impact on a business valuation“. 

If you would like assistance understanding your business’ value, or assessing the value of a potential acquisition contact us for a free informational discussion.